Significant cons of Regency’s PVR Partners acquisition

Regency Energy’s stock closed at $27.83 per unit on October 9, the day before the announcement of the acquisition. On October 10, Regency closed at $25.44 per unit, down nearly 9%.

Slightly dilutive upfront, but Regency maintains that it will grow distributions as planned

Regency management noted on the call discussing the acquisition of PVR Partners, “While the combination is expected to be slightly dilutive to 2014 distributable cash flow, it is not expected to affect anticipated cash distribution growth in 2014.” The growth and amount of master limited partnership distributions are largely determined by an entity’s distributable cash flow—roughly speaking, how much cash is left over after operating expenses, interest expense, and maintenance capital expenditures. The majority of this remaining cash is usually distributed to unitholders.

What Regency means when it notes that the transaction is expected to be slightly dilutive to 2014 distributable cash flow is that this amount of “leftover” cash, on a per-unit basis, is expected to be less for the combined entity than it would have been for Regency alone. This is because even though the combined entity will have greater cash flow than Regency alone, the amount of total units (shares) for the combined company will increase to the extent that the distributable cash flow per unit will decrease—at least in the near term.

However, Regency states that despite this, it will grow its distributions in 2014 as planned. This means that while the acquisition is dilutive to distributable cash flow in the near term, there should theoretically be no cash effect to Regency unitholders. While MLPs distribute substantially most of their distributable cash flow to unitholders, they target cash distributions to be somewhat less than distributable cash flow so that they’re not paying out all of their excess cash. The ratio of distributable cash flow over cash distributions is called the “distribution coverage ratio.”

Regency has stated in the past that it targets around a 1.1x distribution coverage ratio. That is, it aims to pay out only around 90% of its DCF (discounted cash flow) as cash distributions. (Note that this is in line with most MLPs with similar footprints and cash flow volatility.) Regency has stated that as a result of the acquisition, DCF per unit would decrease, but cash distributions per unit should remain the same. This implies that it will pay out a greater portion of its DCF than it would have otherwise in 2014. This in turn implies that if RGP were targeting around a 1.1x distribution coverage ratio for 2014 before the acquisition, the post-acquisition distribution coverage ratio would likely be somewhere under 1.1x.

In any case, Regency acknowledges that the acquisition will be dilutive in the short term. Regency likely anticipates that the PVR acquisition will bring substantially more cash flow after 2014 to make the transaction accretive to distributable cash flow in the long term. Otherwise, it makes little economic sense to complete the acquisition. However, note that this means that RGP is relying on PVR’s assets to perform and grow as planned several years into the future, and investors view this as more attractive than an acquisition that would be immediately accretive.